Category: Economic Commentary

How economic forecasts and scenarios can strengthen financial planning

It’s already mid-December 2017. Your organisation has already started (or maybe even finalised) your plans for 2018. You have targets and budgets and tactics lined up to take you confidently into the year ahead. But, did you remember that 2018 is an election year in Barbados? Did you factor that in to your organisation’s financial plans?

Election years are typically characterised by increased government spending (which is often accompanied by increased consumer spending) and greater economic confidence. All of the campaigning and promise-making usually puts everyone in an optimistic frame of mind. Given the state of fiscal affairs in Barbados and the generally depressed economic confidence levels, however, maybe 2018 will buck this trend and it will be more or less business as usual. Or maybe the pessimists amongst us will win the day and 2018 will be the worst year, from an economic standpoint, that Barbados has ever experienced. Has your organisation considered the impact of any of these scenarios?

It has been my experience that the economic forecasts included in corporate financial planning exercises are only baseline forecasts. What do I mean by ‘baseline’? Baseline forecasts typically assume that the future will continue more or less in the same fashion as the recent past. In the case of Barbados, therefore, the next 3 to 5 years – i.e. the usual planning period for corporate budgets – will be characterised by:

low levels of inflation

a fixed 2:1 exchange rate with the U.S. Dollar

economic growth rates around 1%

unemployment around 10%

debt levels over 100%, and,

fiscal deficits over 5% of GDP.

But what if one or more of these assumptions no longer holds?

What if the deficit worsens? What if the exchange rate is adjusted? What if the economy slips back into a recession? What if the country is forced into a programme with the International Monetary Fund? What if 2018 is not business as usual and it’s not a typical election year? What impact will these scenarios have on your organisational plans?

And did you consider how economic policy may change depending on which party is elected?

Each party has different ideas on how the country should be run and where emphasis should be placed. Therefore, depending on which government wins the elections, your plans may no longer be relevant.

Including economic forecasts and scenarios into corporate financial budgeting exercises can help you plan for various plausible futures. Not only will you feel better prepared, whichever outcome, but you will also have a better understanding of the likelihood of each scenario, which would allow you to adjust your resources accordingly. Antilles Economics offers a comprehensive range of economic advisory services – for example, workshops, customised forecasts/scenarios and internal stakeholder briefings – that can provide forecasts and scenarios. And, there are various government agencies that publish their expectations about the future, as well as IMF reports and advisories from the international rating agencies. Once you’re confident that you can translate that information into meaningful intelligence for your organisation, they are reliable and trusted sources of economic data.

I’m looking forward to 2018. I think it will be a very interesting year from an economic standpoint. But what may be interesting for us economists, may be devastating for profit-making enterprises. Make sure you’re prepared.

The current state of the Barbados economy

The latest review of the economy from the Central Bank of Barbados (CBB) stated that real GDP in Barbados rose by 1.6% in 2016, compared to 0.9% in 2015, on the back of the tourism industry – long-stay arrivals rose by 6.3% for the year up to December 29. Industries connected to tourism – reflected in sectors such as transport, distribution, utilities, construction and other services – all performed modestly, and these performances contributed to a decline in the unemployment rate to 10.2% at the end of September 2016 from 11.3% at the same point of 2015. The story from the renewable energy industry was also quite promising, with the addition of a 10 megawatt solar photovoltaic farm. As a result of the improvement in economic activity and moderate growth in goods and services exports, the external current account balance improved.

Despite 2016 being the third consecutive year of real GDP growth according to the CBB, the Barbadian economy is still not out of the woods. In fact, it is probably in one of its most dangerous phases since the downturn began back in 2009. The foreign exchange reserves have dropped to 10.3 weeks of imports of goods and services – almost two weeks below the internationally accepted floor of 12 weeks – and the fiscal deficit remains high at a provisional 8.2% of GDP. The drain on the reserves has been caused by a severe reduction in net capital inflows – from $371.8 million in 2015 to $136.1 million in 2016 – while the government seems incapable of reigning in its current expenditure in line with the lower revenue collections. The CBB has been placed in the difficult position of printing money to finance the government’s operations, which has not helped the current low-confidence environment that is at least partially responsible for the fall in net capital inflows.

Policy Options

Policy debates have so far centred on devaluation of the Barbados dollar and/or entering into a financing agreement with the International Monetary Fund (IMF). Our view is that neither of these options would work without the supporting structural changes. Barbados is a net-importer of goods and has limited capacity to substitute imports for locally produced goods should the currency be devalued and imported goods become relatively more expensive. Devaluing the currency would simply make consumption more expensive in an environment where the population has little room to cut back. Already the levels of both personal consumption per capita and personal savings at banks and credit unions have remained relatively unchanged since 2014. For devaluation to work in this economy, the local production capacity would have to increase to such a degree that it seems almost impossible, even in the medium-term; at present, exports of goods represent a mere 16% of retained imports. Concessionary financing appears attractive, but when you consider that the IMF has been advocating for devaluation as one of its policy reforms, the luster starts to fade. Furthermore, the success of IMF programmes, when well-designed, hinges on timely and effective execution, and Barbados does not have a good track record in recent times when it comes to policy execution.

Barbados has to make some difficult decisions and commit to long-term structural change that is sustained beyond political cycles. Many of these changes are in the hands of the private sector. Yes, the government can improve business processes and take its role as a facilitator of business more seriously. We would all welcome more streamlined and transparent processes, with predictable turnaround times and efficient, productive staff. But the economy is the sum of the production of mainly businesses. If the economy is struggling, it’s because businesses are struggling.

Some have argued that Barbados is too tourism-dependent, so when arrivals are down, it affects too large a proportion of businesses in the country and makes the economy too vulnerable. Though there are some large, successful producers, the manufacturing sector is too fragmented, which does not lead to the economies of scale required to produce efficiently in most sub-industries. Agriculture has tremendous room for growth, but once again it may be too fragmented, which contributes to the acres and acres of idle land and inefficiencies that prevent strong, sustainable linkages with other large industries. Renewable energy has great potential for both reducing the amount of imported fuel as well as lowering the overall cost of energy, but the ability of this industry to propel the country out of its woes will hinge on the timing of investments. And the cultural industries, long lauded as the future of economies all across the Caribbean, are still too disorganized to even facilitate a reliable estimate of its size.

The short-term policy options can be boiled down to two interconnected themes: create some breathing room and raise confidence. In the public sector, government can reduce its deficit by reducing both the expenditure of state-owned enterprises and the government’s wage bill. Doing so should provide the government with the financial space to tackle its arrears and reform the entire public sector, both of which would go a long way to improving the public’s trust. Demonstrating that it is committed to fiscal responsibility would also assist with negotiations to gain low interest rates on any future debt.

The private sector is willing to lend its support and demonstrated this by its recently called for a return to active dialogue and cooperation under the Social Partnership. The Social Partnership is a series of protocols that commits the Government of Barbados, labour (represented by the Congress of Trade Unions and Staff Associations of Barbados) and business (represented by the Barbados Private Sector Association) to cooperating to develop the economy in the long-term interests of the country. The last protocol expired in 2013. A return of the Social Partnership would not only raise the confidence of residents, but could also assist the government with tackling arrears and ensuring a smooth adjustment of its wage bill.

But the devil is in the details and that’s where all planning discussions start to fall apart.

Last week on a popular radio show in Barbados, two leading economists and a former head of a large company in Barbados discussed and took calls from the public on the Barbados economic recovery. I found the discussion extremely interesting and I commend all of the panelists for their insights. At the same time, however, I found myself wondering if the discussion was framed correctly.

Be careful what questions you ask, you may just get answers

I believe that you only get answers to the questions you ask. So, for example, if I asked you if you thought that an umbrella would help reduce the heat from the sun, we could have a long discussion on the usefulness of umbrellas, their design, the materials they are made out of, when they are most effective, etc. We may not discuss if the temperature was actually high enough that day to warrant a solution in the first place. We may not discuss if there were other solutions to reducing the impact of the sun’s heat. We may not discuss the benefits of exposing oneself to the sun’s rays. We would focus our discussion on answering the question asked: would an umbrella work.

So, when we ask panelists whether Barbados is in a crisis, they respond with their opinions on what defines a crisis and therefore whether they believe we are in one. When we ask them if the government or the private sector should be the one to get us out, they debate the effectiveness of each option as a means to solving the current problems. When we ask them for specific examples of what we should do to get out of the current crisis, they list suggestions from strengthening tourism, cutting government expenditure, and retraining the labour force.

These are all valid points. Very few people would have any major disagreements. Furthermore, all of their suggestions could work. Unfortunately, this leaves us with no clear idea of what to do next and what I consider to be the ‘too much choice’ dilemma: when faced with too many options we opt to choose none.

We need to frame our discussion around solving ourlong-term or structural problems first before we can identify the best short-term actions.Policy decisions, probably more than most other types of decision-making, is about long-term planning because timing is the most critical factor in macroeconomic policy. The ‘right’ policy implemented at the wrong time will not work just like the ‘wrong’ policy implemented at the right time will not work. The only combination that works is the ‘right’ policy at the right time.

We created our structural problems by answering the wrong questions before. When government needed more revenue, it added the Value Added Tax (VAT), which did not address the underlying problem of insufficient production in the economy. When the VAT was raised, it did not address the underlying problem of declining production and consumption. When unions demanded pay increases, it did not address the challenge of falling corporate revenue and labour productivity. When companies cut marketing budgets and raised prices, they ignored the fact that consumer demand was falling. All of these solutions were aimed at fixing some short-term challenge. But in the end, they deepened structural weaknesses and contributed to yet another round of problems.

Solving our structural challenges requires us to ask the right questions. What if instead we had asked the panelists for their view of the ‘ideal’ economy of Barbados before we asked any other question? Maybe they would say that it was less dependent on tourism; the government was smaller; the labour force was more flexible; the exports were more diversified; the infrastructure and institutions were stronger; or some other goal or combination of goals. Whatever the goal, we can then debate how we achieve it.

All other questions, and their answers, should be framed with our long-term goals in mind. Suppose we determine that a smaller government was critical to our vision of the ‘ideal’ Barbados economy. Maybe we would be much more supportive of cutting the size of the civil service, embracing technology for standardised government services and divesting of government-owned companies.

The same thinking applies to becoming less dependent on tourism, for example. With this as our goal, maybe we would be hesitant to grant additional subsidies and more financial resources to the hoteliers. Maybe we would revisit our legislation for our international financial services sector to encourage growth in this industry. Maybe we would embrace science and technology more in our agricultural sector to compensate for the physical challenges the industry faces.

As highlighted with these two very different goals, the solutions presented not only shift the economy closer to becoming our ‘ideal’ economy, but they could also help solve the current problems. By having the goal in mind, we also have removed some options from the discussion because they do not help us to achieve our goal.

I believe that asking the right questions is key to solving Barbados’ structural problems so let’s start the discussion. What is your vision for the ‘ideal’ economy of Barbados?

Over the last few months we have all listened to the robust debate between our politicians and other interested observers regarding whether Barbados is holding an adequate level of foreign exchange reserves. While the debate has been useful, there is an implicit assumption that the international benchmark of an adequate level of international reserves is a good indicator. That may not be the case.

Why do we care about the reserves?

Before we can debate the benchmark, we need to understand why we even care about the level of the reserves. A simple way to think of the reserves is as a backup foreign currency savings account. Consider this simple example:

Barbados receives money from selling its goods and services to other countries or when other countries invest in Barbados (foreign exchange inflows);

Barbados has to spend money on goods and services it purchases from other countries or when it invests in other countries (foreign exchange outflows);

If it spends more than it earns, it needs to make up the difference with savings (reserves).

If you run out of savings, how will you pay your foreign currency bills?

In fixed exchange rate economies like Barbados, international reserves allow the central bank to make the implicit guarantee that it will be able to convert local currency to foreign currency on demand. Think about what would happen if the Central Bank of Barbados could no longer fulfil its promise to exchange two Barbados dollars for one United States dollar. This would mean that in order to purchase materials from abroad, you would have to obtain foreign exchange from a foreign exchange dealer and pay whatever price the dealer demands for foreign currency. In these circumstances, the market exchange rate would deviate from the pegged rate – i.e. the market exchange rate would no longer be 2:1 – forcing the authorities to abandon the peg. When you consider that we import almost all of what we consume, instability in the foreign exchange market would have wide-reaching consequences.

It is therefore not difficult to understand why so much emphasis is placed the international reserves in fixed exchange rate economies. It indicates to investors (both local and foreign) whether the peg is sustainable, and therefore the risk of exchange rate-related losses if they were to invest in the country.

Why it is important to have the right benchmark level?

I like to think of the current reserves debate as similar to steering a ship while tracking the development of a hurricane. We rely on our meteorologists to keep a close eye on every patch of cloud in the sky and watch how it develops. We expect to get warnings long before a harmless cloud becomes a hurricane. We expect to be told how quickly it was developing and when and where to expect it to hit. We may not fully understand how they do it, but we assume meteorologists have thresholds that they compare developing storms to.

But what if their thresholds are wrong? Or, what if their thresholds only signalled an approaching hurricane when we were already in the midst of it? There is nothing wrong with having thresholds. The challenge is obviously if the thresholds are adequate and give us enough time to prepare. That is the concern I have about the internationally accepted benchmark of an adequate level of reserves. I think we all accept that the country’s external position is at a very vulnerable point, but is it too late now to do anything about it?

The current benchmarks

So what level of reserves is needed to maintain the peg and support investor confidence? Economists have two popular indicative rules of thumb. One of the most quoted in local debates is 3 month or 12 weeks rule: reserves should be able to cover 12 weeks or 3 months of projected imports. It is important to know that there is no statistical justification for this ratio; it is just a figure that has become a focal point for economists. It is also subject to criticism as it ignores financial flows and focuses solely on the flow of goods and services. In a country like Barbados, this is an important failing, because while we import more goods and services than we export, we have historically attracted more capital than we have been sending abroad.

Another widely used indicator is the ratio of reserves to broad money (or the amount of printed currency as well as checking and savings deposits in a country). Consider the basic commercial banking model. Banks accept deposits from people that have surplus funds and then lend these funds to people that are in deficit and need to finance their activities. Banks therefore never have all of the deposits that they have collected in their vaults. The model works, since only a fraction of depositors would demand access to their funds on any given day. The same thing applies with reserves. If you think of the amount of money in a country as the deposits, only a fraction of these ‘depositors’ or holders of local currency would want to convert their local currency into foreign currency on any given day. The benchmark considered adequate in this instance is that reserves should be around 20 percent of broad money, i.e. only 20 percent of the money supply would need to be converted into foreign currency in the short- to medium-term, whether it is for goods purchases or investment purposes.

An alternative benchmark level

While I think that these two ratios are useful, I disagree with the benchmark levels that have been treated as sacrosanct in local debates because they ignore the many other factors that need to be considered when determining the benchmark in the first place. It’s similar to if we are only informed of an approaching hurricane when rain has already started to fall and winds are already creating 20-foot waves. Our international reserves benchmarks are far too low to be meaningful as a signal of distress.

Now let’s go back to the question we raised in the beginning: are the level of reserves Barbados currently holds adequate?

Looking at the benchmark indicators, you could conclude that the level of reserves appears to be adequate. The reserves currently cover 13.3 weeks of imports of goods and services and at March 2013 were 22% of broad money. In both cases the country is above the benchmark levels so we should be in the clear. However, the story is a bit more complicated.

Consider these three facts:

Small states are more vulnerable to natural disasters and therefor require larger amounts of foreign currency to finance recovery efforts;

Foreign currency flows quite freely in and out of the country and we have limited ways to control it;

We have a very large public sector that drives a large proportion of the country’s foreign currency consumption.

This would imply that we would need to have a larger cushion than countries that do not have these characteristics. We have derived an ideal target of 22 weeks for the ratio of reserves to imports (see the recent paper where we determined the optimal level of reserves based on a statistical cost benefit analysis for more information)[1]. This is almost twice the rule-of-thumb of 12 weeks and is a direct result of the high probability of natural disasters in small states.

Even this target, however, should not be viewed as sacrosanct. We found that small states that were able to implement a prudent government expenditure management framework would be able to hold a smaller stock of reserves, without leading to a disruption of normal import and export activities or any negative impact on short- to medium-term growth. Though the latest Central Bank of Barbados press release showed declining expenditure levels, the fiscal deficit was still estimated at a relatively high 8% for the 2012/13 fiscal year.

In short, it is important that we monitor the level of international reserves in countries such as Barbados. It is equally important that we independently determine what level is the minimum that we need to comfortably meet our obligations.

The Central Bank of Barbados (CBB) released their review of the economic performance of Barbados for the first nine months of 2013. As expected, the country slid deeper into recession and the CBB estimates that economic activity declined by 0.7% so far for the year. The key drivers of economic activity – tourism and construction activity – continued to struggle, the unemployment rate remains high and the level of reserves continued to plummet. The only good sign is the continued ease in inflation, though one could argue that the low inflation rate (2.1% at July 2013) may partially reflect low demand, especially in an import-dependent country, such as Barbados, where high levels of consumer confidence are often accompanied by a rising inflation rate.

Confidence and the Foreign Exchange Reserves

Perhaps the most worrying trend is the continued leakage in the foreign exchange reserves, which fell by Bds$220.2 million in the third quarter of 2013 and is now at its lowest since 2000. To be prudent, countries with fixed exchange rates are encouraged to maintain foreign exchange reserves equivalent to at least 12 weeks of imports of goods and services. This level is believed to provide sufficient foreign exchange coverage to successfully defend the exchange rate and thus provides a signal to international investors of the strength of the Balance of Payments position and, by extension, the entire economy. At 13.3 weeks, Barbados is only 1.3 weeks above this international benchmark. Unlike the last period of significant drain on the reserves, the reduction in the reserves is not due to a fast-growing import bill. In fact, retained imports have grown by a mere 0.05% so far for the year since domestic demand is quite weak.

The main obstacle to arresting the slide in the reserves has been attracting capital inflows. The CBB estimates that net capital inflows at the end of the third quarter are roughly one-quarter of what was recorded by the same point in time in 2012. Capital inflows, especially foreign direct investment, are good indicators of the level of confidence in an economy. In times where confidence is high, inward investment grows, as both domestic and foreign investors are comfortable making the long-term investments that attract capital inflows, such as major construction projects, buying real estate and starting/expanding companies. On the flip side, when confidence is low, not only do foreign investors become increasingly reluctant to make long-term commitments, but domestic investors also go into a holding pattern, since low confidence in the future of the economy increases the risk of these types of investments.

The CBB believes that 2014 should be better year for foreign direct investment due to the construction of a cruise pier and the implementation of government infrastructure and tourism-related projects. Furthermore, it anticipates that capital inflows will strengthen even further in 2015. This outlook hinges on major projects coming fully on stream and the success of initiatives to strengthen Barbados’ international competitiveness.

There are clear downside risks to this outlook. Private-sector projects have been subject to above-average financing constraints in recent years, partially due to the uncertainty surrounding long-term investing in Barbados. The government is also in the middle of a major fiscal contraction, which could prevent or significant slow the implementation of major infrastructural projects. There are signs that confidence may returning, however, with the major commitment recently made by Sandals Resorts International and the addition of another Jet Blue flight to Barbados.

Operating with Economic Uncertainty

Operating with this level of economic uncertainty is a major challenge for businesses operating in Barbados and presents a catch twenty-two situation for the country. Without investment and confidence in the future of the country, it would be difficult for the economy to rise out of recession. On the flip side, it is risky to invest in a country that has been in recession for a prolonged period of time, especially when the economic outlook is somewhat unclear. Nevertheless, we may be at a turning point in the country’s history where the timing may be right for the private sector to firmly take the reigns of the economy and lead Barbados to sustainable growth.